The Fed Holds Rates Steady, but Warsh’s Attempt to Outsource Tightening to the Market Backfires, with Negative Consequences Becoming Increasingly Apparent

Warsh’s ideal scenario was not complicated. His primary short-term objective was to rebuild the Federal Reserve’s credibility and "make the dollar great again." From a strategic perspective, an "unexpected" policy choice would help the market break its dependence on forward guidance. Raising rates ahead of or in line with the curve would be more effective in reducing the risk premium, as higher short-term interest rates could help bring down long-term yields, especially in an environment of unstable inflation expectations. Warsh’s calculation was simple: use a hawkish stance to suppress long-term yields, thereby controlling inflation without actually raising interest rates.

However, the reality turned out quite differently. Markets became concerned that inflation could spiral out of control and demanded higher risk compensation. The 30-year U.S. Treasury yield surged by as much as 14 basis points in a single day, reaching 5.23%, its highest level since 2007. At the same time, market-based inflation expectation indicators rose, while the U.S. dollar weakened.

Even more noteworthy was the structural signal: the yield curve experienced an unusually sharp steepening. Short-term yields (2-year Treasuries) declined because markets believed the likelihood of near-term rate hikes had decreased. Meanwhile, long-term yields (30-year Treasuries) climbed as investors demanded greater compensation for inflation risk. This combination of falling short-term yields and rising long-term yields marked one of the steepest post-Fed meeting yield curve steepenings since the mid-1990s.

Ben Emons, Managing Director of Fixed Income at Highline Asset Management, pointed directly to the issue: "This shows that Warsh’s policy strategy lacks credibility." He further explained, "Taking a hawkish stance without acting is a convenient way to let the market judge for itself and effectively tighten policy on the Fed’s behalf. But once inflation accelerates and markets conclude that the Fed has fallen behind the curve again, the strategy becomes counterproductive."

The Risks of Warsh’s Approach

Negative Impact One: The Federal Reserve’s Credibility Is Being Eroded

Warsh’s strategy of "letting long-term yields do the work for me" has had the most immediate consequence of undermining the Federal Reserve’s policy credibility. With inflation remaining above target, this approach can easily weaken market confidence in the Fed’s ability to execute effective monetary policy. The sharp rise in long-term Treasury yields and the pronounced steepening of the yield curve after the meeting reflected investors pricing in higher long-term inflation and policy risks.

Huatai Securities had already anticipated this risk before the meeting. Its analysis suggested that if the Fed did not raise rates in July while Warsh continued to strictly implement the new framework of abandoning forward guidance, the bond market could begin pricing in Warsh as merely "bluffing." Investors might even attempt to ease financial conditions deliberately, forcing the Fed to raise rates in September and potentially requiring a larger hike. That is precisely what now appears to be unfolding.

Torsten Slok, Chief Economist at Apollo Global Management, told Bloomberg Television that Warsh’s "silent" strategy of abandoning forward guidance had caused Treasury yields to move "like a yo-yo." Before Warsh, markets typically assigned around a 90% probability to the expected policy path ahead of Fed meetings. Before this meeting, however, CME FedWatch showed only about a 38% probability of a rate hike. Even more dramatically, during Warsh’s press conference, the probability of a September rate hike fell in real time from roughly 70% to 50%.

Slok said, "The market can hardly find any anchor to rely on. It's also difficult to understand what today's decision is based on." He also pointed to the deeper meaning behind the surge in the 30-year yield: "If you won't hike, we will." The bond market had decided to tighten financial conditions on its own—precisely the backlash against Warsh’s logic of "letting the market do the work." The market is indeed doing the job, but not in the way the Federal Reserve intended.

Negative Impact Two: Three Dissenting Votes Expose Internal Divisions

Another unusual aspect of this meeting was the presence of three dissenting votes. Cleveland Fed President Beth Hammack, Minneapolis Fed President Neel Kashkari, and Dallas Fed President Lorie Logan all voted in favor of an immediate 25-basis-point rate hike. This marked the first time since 2016 that three FOMC voting members had cast dissenting votes in the same direction during a single policy decision.

Barclays economists described the outcome as a "hawkish hold," noting that "the three dissenting votes will fuel expectations for future rate hikes over the coming months." The public display of internal divisions further weakened market confidence in the Fed’s policy direction. When the Chair says, "Long-term yields are doing the work for me," while three regional Fed presidents say, "We should raise rates now," the market is left wondering whom it should believe.

Negative Impact Three: Systemic Pressure on Risk Assets

The surge in long-term yields is now spreading to risk assets. Following the press conference, all three major U.S. stock indexes plunged in late trading. The Dow Jones Industrial Average fell more than 1,100 points, marking its largest single-day point decline in 15 months. The Nasdaq dropped 1.74%, while the S&P 500 lost 1.52%. The Philadelphia Semiconductor Index tumbled 5.33%, with every constituent stock closing lower. Micron Technology fell nearly 10%, SanDisk dropped more than 7%, while Nvidia and SpaceX both declined by more than 3%.

Warsh stated that "long-term yields are already doing the work for me." From a technical perspective, that statement is correct: long-term yields are indeed rising, and financial conditions are indeed tightening. The problem, however, is that long-term yields are rising not because markets believe the Federal Reserve can control inflation, but because they no longer believe it can.

When investors demand greater compensation for inflation risk, when the 30-year Treasury yield reaches its highest level since 2007, and when the yield curve steepens at one of its fastest paces since the 1990s, these signals all convey the same message: the market believes the Federal Reserve has fallen behind the curve. Warsh attempted to "outsource" monetary tightening, but the market completed the job on its own terms. The result has not been inflation brought under control, but rather the beginning of a test of the Federal Reserve’s credibility in the U.S. Treasury market.